Editor's Note: This story originally appeared on SmartAsset.com.
New research from Vanguard suggests that investing in commodities is the most powerful way to hedge against unexpected inflation. Pointing to a concept known as inflation beta — an asset’s predicted reaction to a unit of inflation — Vanguard found over the last decade that commodities rose between 7% and 9% for every 1% of unexpected inflation the economy experienced.
The Vanguard research, which examined the historical returns of the Bloomberg Commodity Index, comes as national inflation has reached levels not seen in more than a decade. The Consumer Price Index recently surged to its highest point since summer 2008, rising 5.4% in the 12-month period that ended in July.
While markets factor a certain level of inflation into the price of assets, unexpected inflation can wreak havoc on portfolios by diminishing investors’ purchasing power, making effective inflation hedges all the more valuable.
What Are Commodities, and How Do They React to Inflation?
Simply put, commodities are raw materials or agricultural products that can be traded. Common examples of commodities are gold, oil, grain, natural gas, beef and even coffee. Because they are crucial to everyday life, investors see the inherent value in owning and trading commodities.
As economic forces push the price of goods and services upward, commodities often become more expensive during times of hyperinflation. For example, energy commodities, which include oil and all types of gasoline, rose in price by nearly 42% for 12 months ending in July, according to CPI data.
Sue Wang, an associate portfolio manager for the Vanguard Quantitative Equity Group, led the research that determined the inflation beta of commodities was between 7 and 9 over the last decade. “This suggests that a 1% rise in unexpected inflation would produce a 7% to 9% rise in commodities,” Vanguard wrote in its recent insights.
Commodities vs. Other Asset Classes
The Vanguard research notes that commodities are more potent inflation hedges than both inflation-protected bonds and equities.
Treasury Inflation-Protected Securities (TIPS) are commonly used inflation hedges that shield investors from a decline in purchasing power. The principal value of TIPS grows at the rate of inflation, preserving the buying power of an investor’s money. “But with a far lower beta to unexpected inflation (around 1), they would require a significantly higher portfolio allocation to achieve the same hedging effect as commodities,” according to Vanguard.
Meanwhile, equities have recently shown to be an effective inflation hedge, especially during the low-growth, low-inflation years of the 2010s. The S&P 500 has even slightly outpaced Bloomberg Commodity Index over the last year, but Vanguard believes the hedging power of U.S. equities will likely diminish in the future. This will be seen as technology and consumer discretionary sectors comprise more of the equity market while commodity-related sectors comprise less of it, according to Vanguard.
How to Invest in Commodities
Investors hoping to put money into commodities have several different options for doing so. They can invest in commodities in the form of futures contracts or buy them indirectly through stocks. Commodity mutual funds and exchange-traded funds (ETFs), meanwhile, can offer broad exposure to commodities while forgoing some of the risk that accompanies futures trading.
If you’re interested in investing in commodities, consider working with commodities trading advisers (CTAs), certified financial professionals who can provide specific advice related to commodities and futures trading. A CTA, which can be a person or company, manages investment accounts and trades futures for their clients.
Commodities are naturally occurring or agriculturally grown goods that can be traded in a number of ways. During times of unexpected inflation, investing in commodities can hedge against rising prices and preserve buying power. Citing historical data, Vanguard research suggests commodities rise between 7% and 9% for every 1% of unexpected inflation, making them more effective than TIPS and more reliable than equities.
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